Later today we will likely hear that the United States Federal Reserve will raise interest rates, perhaps more than was expected just a few weeks ago. What will this do to the price of oil, which is currently in a weeklong slide?
When the value of the U.S. dollar increases, the global price of oil drops, because oil is most commonly sold in dollars. A more valuable dollar can buy more oil. Conversely, a weakened dollar buys less oil, so when the dollar depreciates the global price of oil rises.
What, then, does an increased interest rate do to the value of the dollar? The standard academic answer has been that increased interest rates cause an appreciation of the dollar. However, the U.S. Federal Reserve Bank of St. Louis notes that the historical record indicates otherwise. In a very clear explanation, economist YiLi Chien and analyst Paul Morris note that interest rate hikes cannot be used to forecast the movement of the dollar’s value in the short term. If anything, “there is weak evidence that a high-interest-rate currency actually has a tendency to appreciate.”
If and when the Federal Reserve raises interest rates, oil speculators may very well operate under the assumption that the interest rate hike will cause the dollar to appreciate. Alternatively, some expect speculators to act in the opposite direction. If speculators forecast a depreciated dollar, they will buy into oil and may cause a price bump.
The opposite would happen if they forecast a dollar appreciation. However, the historical record shows that there is no way to predict how the dollar will react to an interest rate hike. In other words, the Federal Reserve’s actions cannot be used to accurately forecast the direction of oil pricing.
Investors should continue to focus on production levels, particularly:
- Saudi Arabia’s recent announcement that it raised its production in February (which they say will be placed in storage, not exported);
- Expectations for increased gasoline production in the U.S. which will draw down the high levels of stored crude; and
- Russia’s commitment to the production cut agreements